Inflation and equity markets: A lesson from Buffett

Wednesday 15 June, 2022

Inflation, interest rates and geopolitical events have driven markets so far this year. Although, these three factors are all inextricably linked, this snapshot focuses on why equity markets are impacted negatively by inflation over the short-term.

Why do we invest?

An obvious answer is to make a real return over the period of investment. In other words, to maintain purchasing power. As Warren Buffett wrote about in a letter to shareholders in 1979, he is looking for “a reasonable gain in purchasing power from funds committed for you as shareholders”^[1]. At this time, the US inflation rate was circa 11.4%^[2]. 

Warren went onto say that if you put money into a 3% savings bond or an 8% Treasury bond, these investments have been “transformed by inflation that chew up, rather than enhance purchasing power”. 

Buffett brought this altogether into an investor’s ‘misery index’, which is:

• The rate of inflation or put another way, the annualised loss of purchasing power
• The tax paid on an investment (income tax, dividend tax, Capital Gains Tax )

Inflation eats away at the purchasing power of businesses as well. What are their options?

• Pay the higher supply costs and take lower margins
• Pass on these rising costs to their customers

As we have seen, inflation pushes up interest rates which makes the cost of corporate borrowing (existing and new) rise, which impacts the balance sheet. In the real world, this means investors are pricing in the risk that the Federal Reserve might raise interest rates by 75bps this week.

According to Buffett, which businesses are better to own in periods of persistent and high inflation?

Businesses that have:

• Companies with moats: The ability to increase prices without significant loss of market share. Companies with ‘moats’ have better and more resilient pricing power. Think Microsoft.  There is no escape if you want Word, Excel etc.
• Scalable companies: If a business cannot pass on costs to the consumer, then they may need to increase the amount of business they are doing. This means lower margins would not impact (or would impact less) the balance sheet.

Simon Prestcote, chartered wealth manager, Lonsdale Services North London said:

‘As we are experiencing a period of high inflation because of rising food, fuel and energy costs, Buffett and the likes of Terry Smith remind us that the best strategy is to own great businesses.  This period is painful and will continue to be so for at least the foreseeable future.   However, we always advise our financial planning clients to invest for the medium to longer term, normally over five years, so they don’t have to worry about short-term market movements.  Although we may experience economic uncertainty it is worth remembering that when markets are volatile, they can often rebound unexpectedly and quickly so if you aren’t invested you will miss out.  For this reason, we recommend our clients don’t act hastily.  Historically some of the worst days in the investment markets are followed by some of the best days and missing these can affect your long-term return.  Remember if you sell and you want to reinvest you must time your exit but also your re-entry. For more information about the benefits of long-term investing and holding a diversified portfolio read: Time in the market not timing the market and Mark Slobom’s article - Actions to take in volatile markets.  If you would like local financial advice please contact our financial planning teams in North London, St Albans, Ware, Harpenden, Stafford, Leeds / Bradford, Ringwood, and Chippenham, or complete our booking consultation form and one of our qualified financial advisers will contact you to arrange an initial meeting.’

Please note: The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested.

[1] https://www.berkshirehathaway.com/letters/1979.html

[2] Factset

 

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